Case problem 3: HART VENTURE CAPITAL

Hart Venture Capital (HVC) specializes in providing venture capital for software development
and Internet applications. Currently HVC has two investment opportunities: (1) Security
Systems, a firm that needs additional capital to develop an Internet security software package,
and (2) Market Analysis, a market research company that needs additional capital to develop a
software package for conducting customer satisfaction surveys. In exchange for Security
Systems stock, the firm has asked HVC to provide $600,000 in year 1, $600,000 in year 2, and
$250,000 in year 3 over the coming three-year period. In exchange for their stock, Market
Analysis has asked HVC to provide $500,000 in year 1, $350,000 in year 2, and $400,000 in year
3 over the coming three-year period. HVC believes that both investment opportunities are worth
pursuing. However, because of other investments, they are willing to commit at most $800,000
for both projects in the first year, at most $700,000 in the second year, and $500,000 in the third
year.
HVC's financial analysis team reviewed both projects and recommended that the company's
objective should be to maximize the net present value of the total investment in Security Systems
and Market Analysis. The net present value takes into account the estimated value of the stock at
the end of the three-year period as well as the capital outflows that are necessary during each of
the tree years. Using an 8% rate of return, HVC's financial analysis team estimates that 100%
funding of the Security Systems project has a net present value of $1,800,000, and 100% funding
of the Market Analysis project has a net present value of $1,600,000.
HVC has the option to fund any percentage of the Security Systems and Market Analysis
projects. For example, if HVC decided to fund 40% of the Security Systems project, investments
of 0.40($600,000) = $240,000 would be required in year 1, 0.40($600,000) = $240,000 would be
required in year 2, and 0.40($250,000) = $100,000 would be required in year 3. In this case, the
net present value of the Security Systems project would be 0.40($1,800,000) = $720,000. The
investment amounts and the net present value for partial funding of the Market Analysis project
would be computed in the same manner.

Managerial Report
Perform an analysis of HVC's investment problem and prepare a report that presents your
findings and recommendations. Include (but do not limit your discussion to) a consideration of
the following items:
1. What is the recommended percentage of each project that HVC should fund and the
net present value of the total investment?

Statement of the Problem:

The problem faced by HVC is whether to invest in both projects in a certain proportion or to
invest in either of the two with the objective of maximizing the net present value. HVC believes
that both investment opportunities are worth pursuing.
Objective:
To maximise the net present value of the total investment in Security Systems and Market
Analysis.
Decision Variables:
Let S= fraction of the Security Systems project to be funded by HVC
M= fraction of the Market Analysis project to be funded by HVC

Objective Function:
Max $1,800,000S+$1,600,000M

Constraints:
$600,000S+$500,000M<= $800,000 Year 1
$600,000S+$350,000M<= $700,000 Year 2
$250,000S+$400,000M<= $500,000 Year 3
S <= 1 Maximum percentage of S
M <= 1 Maximum percentage of M
S, M>=0
Recommended percentages of each project and present value of Total Investment
Solution:
Two feasible solutions:
(1) S= 77.8%; M=66.7% | S=77.7777778% M=66.6666667%
(2) S = 60.9%; M=87% | S=60.8695652% M=86.9565217%

Testing of solutions to get the optimal solution:

Max $1,800,000S+$1,600,000M
(1) $1,800,000 (0.778) +$1,600,000 (0.667) = $2,467,600
(2) $1,800,000 (0.609) +$1,600,000 (0.87) = $2,488,200

Since the objective is to maximize the net present value of the total investment, (2) is the
optimal solution with S= 0.609 and M=0.87. In other words, the recommended
percentage is approximately 61% of the Security Systems project should be funded by
HVC and 87% of the Market Analysis project should be funded by HVC with an
approximate net present value of $2486957 (using S = 60.8695652% and M =
86.9565217%) then rounded off to the nearest whole number).

2. What capital allocation plan for Security Systems and Market Analysis for the
coming three-year period and the total HVC investment each year would you
recommend?
 Capital allocation plan for Security Systems and Market Analysis for the coming three-
year period and the total HVC investment each year would be recommended as:
Note S = 60.8695652% and M = 86.9565217%

Security Systems $ Market analysis $ Total $

Year 1 365217.39 434782.61 800000.00
Year 2 365217.39 304347.83 669565.22
Year 3 152173.91 347,826.09 500000.00

In the first year, HVC should invest $365,217.39 in Security Systems and $434782.61 in
Market Analysis, the total investment amount is 800000.00. In the second year, this
company will spend the same amount of money on the Security Systems as the first year
and $304347.83 on Market Analysis, the total investment is $669565.22; in the last year,
HVC can commit $152173.91 for Security Systems and $347,826.09 for Market
Analysis,
The total is $ 500000.00.

3. What effect, if any, would HVC's willingness to commit an additional $100,000

during the first year have on the recommended percentage of each project that
HVC should fund?
New Constraint:
$600,000S+$500,000M<= $900,000 Year 1

New Constraint:
S=68.9%; M=82% | S=68.852459% M=81.9672131%
If HVC is willing to commit an additional $100000 during the first year, the recommended
percentage of the security systems will increase from 61% to 69% and the number of Market
Analysis will decrease from 87% to 82%. The net present value will change to $2550820,
approximately (using S= 68.852459% and M= 81.9672131% then rounded off to the nearest
whole number).

4. What would the capital allocation plan look like if an additional $100,000 is made
available during first year?
Security System ($) Market Analysis ($) Total ($)
Year 1 413114.75 409836.07 822950.82
Year 2 413114.75 286885.25 700,000
Year 3 172131.15 327868.85 500,000
Compared to the capital allocation plan without the additional $100000, HVC’s investment on
the first year in security system would be $413114.75 and $ 409836.07 in Market analysis with
the total investment amount of 822,950.82. In the second year it would spend the same amount
on the security system as the first year and $ 286,885.25 on Market analysis, with a total
investment of $ 700,000. In the last year HVC would commit $172131.15 for Security System
and $ 327,868.85 for Market analysis for a total of $ 500,000.

5. What is your recommendation as to whether HVC should commit the additional

$100,000 in the first year?
Answer: - Having an additional $100,000 in the first year would increase the net value of the
total investment from $ 248,6957to $ 255,0820 with a difference of $ 63,863. But out of the
additional $100,000 on the first year, only $ 22950.82 is required. The slack would be
$77,049.18($ 900,000-$822,950.82). The slack value would be greater compared to not having
an additional $100,000 which is $30434.78. We recommend that Hart Venture Capital would
stick to the original capital allocation plan that is without committing and additional $100,000.